There is an unusual situation developing in the financial market, and I wanted to make sure my clients were aware of it, and aware that we are observing it.
U.S. corporations are issuing bonds left and right, led by International Business Machines Corp., the world’s biggest computer-services company. A week ago, IBM raised $1.5 billion at the lowest interest rate on record; 1%, on 3-year notes. That’s just 0.3 percentage point more than the yield on government debt of similar maturity. The notes have the lowest coupon of the more than 3,400 securities in the Barclays Capital U.S. Corporate Index of investment-grade company debt.
The surge in U.S. corporate bond issuance set a record last month, as yields on the debt fell to the lowest in more than four years. IBM was joined by New York-based Citigroup Inc. and ArcelorMittal, the world’s largest steelmaker, among at least five other issuers marketing debt at the same time. It’s a window of opportunity for companies, as the money is inexpensive and investors seeking yield over Treasuries are plentiful. Strong companies are able to leverage their good balance sheets to take advantage of this situation.
But it is IBM in particular we are focused on, because Big Blue seems to historically have an ability to sell bonds at low rates just before rates climb. If history repeats, rates will again climb, pressuring bond prices. Higher rates would mean losses for bond investors as the value of bonds paying low rates decline when higher rates are available from newer bonds. Remember, IBM is issuing debt today because they think they would have to pay a higher interest rate tomorrow. The bond buyers are buying because they either think that rates will be lower later or they have to park the cash somewhere and have no better alternative.
IBM’s acumen in issuing debt foreshadowed interest rate hikes in 1979, 1989, 1993, 1995, 1996, 2002 and Nov. 2009. The company’s impressive record is why analysts and seasoned investors pay attention, and believe that this may signal a market high for bonds.
This time around, IBM sold debt amid concerns of pending deflation (falling prices). During deflation, interest from bonds issued by stable companies such as IBM becomes more valuable, which may explain the popularity of IBM’s bonds.
But here’s our thinking: If IBM is a great indicator of when interest rates are at a low, and interest rates are going to start to increase, it means a couple of things.
- Refinance the house or car now if you are thinking of it and have not yet done so. In fact, any borrowing that you are contemplating should be done sooner rather than later as rates are likely to go up.
- If you have long-term bond holdings, you need to be sure that you don’t care about the quotation value of the bonds as that is very likely to decline. If the dividend income from those holdings keeps you happy, you are fine. However, if you may need the principal, then it might be a good time to sell debt, just like IBM is doing.
IBM’s thinking in taking advantage of cheap rates is reflected in a statement from Direct TV. Just days ago, DirecTV, the largest U.S. satellite-television provider, sold $3 billion of debt in a three-part offering to capitalize on record low borrowing costs to refinance bank loans and buy back shares. The CEO wants to use the company’s free cash and debt for share repurchases. “We look forward to tapping into what is currently a relatively strong debt market,” the company’s CFO said. DirecTV repurchased more than $1.7 billion of stock in the second quarter and has authorized an additional $2 billion for its stock buyback program. The stock has gained 18.2% this year and is a buy candidate in our managed accounts.
IBM stock yields about 2%. As an investor, if you think the company is solid enough to lend money to and the common stock yields twice as much as the loan, then why not buy the stock? Of course, one of the possibilities for the loan proceeds for the company is that they can earn 1% by repurchasing their stock that yields 2%. That’s a good spot for them to be in. IBM has repurchased about 3.8% of its outstanding shares over the last year. IBM has said only that it will use proceeds for general corporate purposes.
The debt issuance in general seems to indicate investor confidence that the economy will be good enough for the companies issuing debt to be able to repay those loans. Some 77% of companies in the Standard & Poor’s 500 Index that have reported second-quarter earnings beat analysts’ estimates and manufacturing growth in the U.S. and Britain slowed less than expected in July, increasing confidence in the economic recovery.
The million dollar question for the stock market is this: Where will the money go if IBM is correct, interest rates go up and institutions and people start selling bonds? Our best guess is some will go into the stock market and some into cash. The demand for bonds shows confidence in the future. The ability for large companies to be able to sell bonds and the willingness to use these proceeds to buy back stock also shows confidence. So while the market is certainly in the midst of typical summer doldrums, the aforementioned points to renewed strength down the road. We don’t expect current market weakness to spiral down as it did two years ago. It is hard to say where the near term market bottom is, but we expect the market to firm up and rally by the end of the year.